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Putting Your Assets on the Line Every Day

<p>When many people hear the term &quot;asset allocation,&quot; they immediately think of an efficient frontier diagram and the work of a pioneering economist.</p>
<p>A 25-year-old student at the University of Chicago back in the early 1950s, Harry M. Markowitz really needed a thesis topic. In a chance meeting, a stock broker suggested that he investigate the stock market.</p>
<p>At the time, conventional wisdom suggested that investors should pick stocks with the highest expected return rate, without taking risk into account.</p>
<p>Markowitz recognized that this approach neglected a key part of the investment equation. The concept of risk was identified as early as 1654 in the work of French mathematician Blaise Pascal, who worked on a system to determine probabilities related to gambling.</p>
<p>The concept of risk probability was then further studied by British astronomer Edmund Halley, who in 1690 applied it to mortality tables. Halley&#39;s work was later used to help sell annuities and insure sailing vessels and their cargos, which eventually led to the founding of none other than Lloyd&#39;s of London.</p>
<p><b>A Foundation for Success</b>&nbsp;<br />
But it was Markowitz who first rigorously applied the concept of risk to stock portfolios as part of his 1952 essay, &quot;Portfolio Selection.&quot; His research found that diversification is measurably beneficial, and that pairing risky and less risky assets can actually lower portfolio volatility while simultaneously enhancing potential returns.</p>
<p>His early work laid the foundation for more sophisticated statistical concepts, such as mean variance optimization, which became integral to modern portfolio theory.</p>
<p>And for his efforts, Markowitz was recognized with the 1990 Nobel Prize in Economic Services, sharing it with Merton Miller and William Sharpe, both university professors.</p>
<p>While the term &quot;asset allocation&quot; is widely used to describe an investment strategy, it is actually a process.</p>
<p>Indeed, most investment professionals today use asset allocation as part of an overall approach to finances that involves identifying a client&#39;s current investments, risk tolerance, portfolio construction and asset selection, as well as measuring the performance of what they own and what, perhaps, they seek to buy.</p>
<p>The most time-consuming and analytical element of this process centers on asset-allocation modeling. This process involves analyzing hundreds of variables - such as long- and short-term economic forecasts; expected returns for different equity styles, sectors and capitalizations; standard deviation; as well as bond ratings and maturity structures.</p>
<p>Each portfolio combination is then tested for both risk and return characteristics.</p>
<p>But that&#39;s not the end of it!</p>
<p>These multi-asset portfolios are then monitored and adjusted in response to market conditions.</p>
<p>Some asset-allocation programs make adjustments at specific intervals (monthly or quarterly) back to a predetermined static allocation. And other asset managers reallocate assets on a daily basis, using a forward-looking process that is based on a longer-term allocation target.</p>
<p>Yet even as all this new work continues, one thing remains decidedly clear: Asset allocation will continue to be the foundation for many successful investment portfolios.</p>
<p>That&#39;s a lesson we all need to take to heart!</p>
<p><b>Craig Langweiler is president of the Langweiler Financial Group, in Newtown. He can be reached at 215-860-8066 or at: clangweiler@ americanportfolios.com.</b></p>
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